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5 min read . Updated: 05 Nov 2021, 08:39 PM IST About 700 of the wealthiest Americans would have been affected by a proposal from Democrats in Congress. It’s a small number of taxpayers, but the implications are huge
A new tax on billionaires died in Congress almost as soon as it was proposed late last month, but don’t underestimate its significance.
The levy, sponsored by Senate Finance Committee Chairman Ron Wyden (D., Ore.), would have imposed annual capital-gains taxes on about 700 of the wealthiest Americans.
What made this a landmark proposal is that it would have fundamentally altered the way Americans are taxed. As the law works now, people typically owe taxes when a cash event happens—as when a worker is paid wages or an investor sells an asset.
The Wyden proposal would have taxed holdings for a small group of investors, mostly billionaires, based on paper gains in publicly traded companies. In other words, they would have owed tax annually if their shares in a company rose even if they didn’t sell them. Losses would have offset gains, and large losses could have been carried forward or back to other years.
This so-called mark-to-market approach is used by companies, especially financial firms, in reports to investors. But under current tax law, individuals rarely mark investments to the market price annually.
The proposal raised fears among opponents that the tax could be broadened to apply to the assets of less wealthy taxpayers, and that it could create new tax-code complexities requiring further tax changes.
“The billionaire’s tax was a dramatic change in rules that have been around for more than a century," says Michael Graetz, a former Treasury Department official who teaches at Columbia University’s law school.
The principle that investors don’t owe capital-gains tax until they sell (or otherwise dispose of) an asset goes back to Eisner v. Macomber, a 1920 Supreme Court decision issued not long after the modern income tax took effect in 1913. In a 5-to-4 ruling with a strong dissent from Justice Louis Brandeis, the Court held that Myrtle H. Macomber didn’t owe income tax on a noncash dividend of stock shares she received from the Standard Oil Company of California.
The opinion said Mrs. Macomber got “nothing except paper certificates" that didn’t include any gain for her, so they were not income under the 16th Amendment. Taxing her receipt of them would have been unconstitutional.
Many legal scholars think later court decisions revised and limited Macomber’s holding that taxing unrealized gains before a sale is unconstitutional. These later cases stress the practicality of deferring tax until an investment is sold, as it’s easier to determine value then and collect tax when the taxpayer has cash to pay it.
Nonetheless, a few code provisions levy taxes on investment growth before a sale. Well-off Americans who give up U.S. citizenship can owe exit tax on the unrealized gains of U.S. assets such as deferred compensation and retirement accounts as part of the price of expatriation. Some professional traders and others also mark certain assets to market annually.
But in general, Macomber’s principle of deferring income tax until a sale has endured—to investors’ great benefit. For them, the deferral compounds after-tax income, and they can strategize sales to reduce taxes.
“From the time of the decision to now, for better or worse, Macomber has shaped major areas of income tax," says Marjorie Kornhauser, emerita professor at Tulane Law School.
Why the push to change this fundamental tax rule by marking billionaires’ asset growth to market? Supporters offer several reasons.
One is the longstanding criticism that deferring tax on gains distorts markets and produces a “lock-in effect," because investors refrain from selling assets to avoid triggering tax. If they hold until death, their estates avoid capital-gains tax on growth up to that point, and heirs only owe tax on growth after that—and only when they sell. This is known as the “step-up."
Critics also say current law helps wealthy Americans achieve an income- and estate-tax trifecta. First, they avoid taxes by borrowing against their assets, instead of selling them, to fund their living expenses. Then the deferred tax on appreciation is forgiven at death via the step-up. Finally, their estates can largely avoid estate and gift tax through a variety of legal techniques.
“The income-tax deferral on unrealized gains is unfair. It allows the wealthiest Americans to avoid tax during a time of increasing concern with inequality. Most Americans can’t take advantage of these strategies," says Ari Glogower, a professor at Ohio State University’s law school.
For politicians, another attraction is likely the revenue a mark-to-market regime could generate. According to a study by Lily Batchelder and David Kamin, tax professors who are now Biden administration officials, applying it to the publicly traded assets of taxpayers with more than $50 million of annual income might raise $750 billion from 2021 to 2030. (The authors cautioned that their estimates were preliminary and subject to “vast uncertainty." Also, they were for a wider pool of taxpayers than billionaires.)
While the tax on publicly traded assets got the most headlines, the proposal would also have taxed nontraded assets owned by the billionaires. Valuing nontraded assets is difficult, as homeowners who’ve gotten wildly different values from appraisers know.
The proposal wouldn’t have taxed nontraded assets annually, but it added an interest charge to sale proceeds of them—or if assets weren’t sold, then to their value at death—to tax the benefit of deferral. By Ms. Batchelder and Mr. Kamin’s rough estimate, doing so might raise $200 billion from 2021 to 2030 from the same group of taxpayers.
Of course, these issues are moot because the billionaires’ tax was dropped as Democrats worked to reach consensus on their spending plan. But as Mr. Graetz notes, tax proposals that aren’t enacted don’t die, they just go on the shelf for future use.
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